‘Repo to maturity’ transactions are in substance total return swaps, a type of credit derivative. Fallout is worse than Lehman for the exchange-traded futures market.

The “repo to maturity” transactions are in substance total return swaps, a type of credit derivative. So MF failed to meet margin calls on credit derivatives linked to risky fixed income debt. Regulators haven’t learned much from AIG’s debacle. Like the “repo to maturity” transaction, a total return swap is an off balance sheet transaction treated as a sale, but the total return receiver, MF Global, is long both the price and default risk of the reference assets. The total return payer is the legal owner of the reference assets. The attraction of this arrangement is financing and leverage. Naturally, ratings downgrades will trigger increased margin calls. This is all business as (un)usual.

MF Global Admitted “Diverting” Money from Segregated Accounts

What isn’t usual is diverting money from segregated customer accounts. It’s too late to blame “sloppiness, bookkeeping, or accounting,” MF Global admitted it “diverted” money from customers’ segregated accounts.

The fact that MF Global was exposed to default risk and liquidity risk because of these trades and that they were linked to European sovereign debt was disclosed in MF Global’s 10K for the year ending March 31, 2011, a required financial statement filed with the SEC. The CFTC and other regulators had the information right under their noses, but it appears they didn’t understand that they were looking at a leveraged credit derivative transaction that could lead to margin calls that MF Global would be unable to meet.

Even if all the money can eventually be recovered, it doesn’t change the fact the MF Global took impermissible steps.

Liar’s Poker

Here’s a crazy but true side note. Michael Stockman, the chief risk officer of MF Global (as of January 2011), was in our Liar’s Poker training class lampooned by another classmate, Michael Lewis.

More Liar’s Poker

Last week when customers asked for excess cash from their accounts, MF Global stalled. According to a commodity fund manager I spoke with, MF Global’s first stall tactic was to claim it lost wire transfer instructions. Then instead of sending an overnight check, it sent the money snail mail, including checks for hundreds of thousands of dollars. The checks bounced. After the checks bounced, the amounts were still debited from customer accounts accounts and no one at MF Global could or would reverse the check entries. The manager has had to intervene to get MF Global to correct this.

Rogue Trader and Questionable Risk Management

Gary Gensler, Jon Corzine’s former Goldman Sachs colleague and current head of the Commodities Futures Trading Commission (CFTC), had reason to be concerned about MF Global’s risk management. In early 2008, a rogue trader racked up $141.5 million in losses in unauthorized trades that exceeded his trading limits. It seems he accomplished this in under seven hours. In August of this year, MF Global and the underwriters of its 2007 initial public stock offering (IPO) paid around $90 million to settle claims by investors that they were misled about MF Global’s risk management prior to the rogue trader’s actions. Since 2008, MF Global’s financial condition has been nothing to brag about.

CFTC’s Unprecedented Failure to Move Customers’ Assets Before FCM’s Bankruptcy

The exchange-traded futures markets have been shaken to the core. The Bankruptcy Code apparently conflicts with the Commodity Exchange Act, so customers of MF Global have less protection than they otherwise might have had. In the past, the exchanges and CFTC “always” moved customer positions before a Futures Commission Merchant (FCM) declared bankruptcy. The CFTC had ample reason to have contingency plans for MF Global based on publicly available information. Yet the Gensler-led CFTC hasn’t followed this historical precedent when an FCM led by his former Goldman colleague teetered on the edge of bankruptcy.

Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct associate professor of derivatives at the University of Chicago’s Graduate School of Business. Author of: Credit Derivatives & Synthetic Structures (1998, 2001), Collateralized Debt Obligations & Structured Finance (2003), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, September 2008). Tavakoli’s book on the causes of the global financial meltdown and how to fix it is: Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street (Wiley, 2009).

Reprinted with permission. The original post can be found here.

Reuters Breakingviews columnists break down how the Dodd-Frank financial regulatory reform legislation still wouldn’t have caught problems at a smaller firm like MF Global.

“Clearly MF Global is not going to be considered a systemically important institution, so those rules … even those rules are very sketchy in terms of what they do that’s new,” said columnist Reynolds Holding. (more…)

While we’re almost getting sick of writing about MF Global’s problems, we are still getting calls from concerned people, and the situation is far from resolved. There are still no clear answers coming out of the MF Global mess. Reports yesterday were all over the board, with quotes coming out of government agencies intermeshed with quotes coming out of the hearing on the non-broker-dealer side of MF Global’s business, causing even more confusion for people trying to figure out what in the world was going on. It’s a convoluted rumor mill, but as far as we can discern, here’s what’s up:

• An anonymous source from the regulators camp is reporting that MF Global officials admitted Monday to using client funds in the midst of the turmoil. No official confirmation from anywhere else just yet.
• The FBI is now involved and investigating.
• The SIPC  has set-up the preliminary website for filing claims and has started to put the wheels in motion. Based on our understanding, this does not apply to segregated futures accounts- only to securities clients of MF Global.
• In the initial bankruptcy hearing yesterday, the MF Global attorney stated that all funds, “to the best knowledge of management,” but that the subject of the hearing did not relate to the matter because they weren’t discussing the brokerage business.

While the idea of fraud with segregated accounts on this kind of scale is unprecedented (even if it is only 10% of the total funds in segregated accounts with MF Global), the reaction, in our opinion, could have still been handled a heck of a lot better. Regulators and industry participants alike have floundered in the aftermath, leaving investors uninformed (or misinformed) and scared. Even if you do get a hold of someone at one of the regulatory agencies, you probably aren’t going to get a straight answer- aside from, “We don’t know.”

One of the more disturbing questions that no one seems to be effectively answering is whether this is a systemic problem across the futures industry.  That is, are other FCMs comingling their money with customer money? In our opinion, the answer is a most definite no. The problem with MF Global, from our view, was that it turned its back on its primary futures brokerage business upon Corzine’s entry in an attempt to transform into an investment bank, which in turn led to a chain of events which may have led to them using client money to plug holes in their balance sheet.

To our knowledge, that kind of direction is not prominent in the industry. And indeed, some FCMs were reaching out to clients yesterday talking about how they are not involved in such trading.  In our view, every futures-focused FCM (like RJO, RCG, PFGBest, etc. – not the investment banks like Goldman Sachs which also hold FCM status) realize that, in a world where their bread and butter comes from their brokerage clients, the clients’ happiness and security of funds is paramount.  In our view, unless there is/was an industry-wide switch to an investment bank model like Corzine tried, then there is no risk of industry-wide problems such as those at Corzine’s firm.

With that in mind, perhaps the more pertinent question was raised in a post on Dealbreaker from Matt Levine. He postulates:

The main fallout will probably be that if you have the choice to work with a too-big-to-fail bank or a just-small-enough to fail bank, on a whole variety of things, you’re going to go too-big-to-fail. Sure, there are lots of small brokers who are well capitalized and take the time to get the little things right, like segregating customer accounts. But how can you know unless you do a lot of diligence? Easier to just trust that a megabank squarely in the regulators’ sights will get it right – or, if they get it wrong, won’t be allowed to blow up in a way that blows up customers.

There are three things worth noting here.

1. For many in futures trading, MF Global was one of the big dogs. Maybe not a Goldman Sachs, but hey- even Corzine was betting they were too-big-to-fail. Everyone assumed that everyone else was on top of things because of how big MF Global was- despite the fact that they had long since departed from the purpose that had fueled their ascent.  This is the 8^th biggest bankruptcy in US history – making it hard to believe being too small was the problem here.
2. Even if you accept the premise that being at a megabank is the only place to be (because that’s where the bailouts are), the problem is you really can’t be a futures trader at the top half-dozen banks without being a hedge fund which slings 1,000 lots around like it is nothing.  The megabanks don’t have an infrastructure to handle retail futures accounts trading on their own or through managers.
3. The problem with due diligence on FCMs is, in the case of MF Global, traditional due diligence might not have raised any red flags. Their audits had gone off without a hitch. They had seamlessly responded to capitalization calls earlier this year. Their reporting was looking good. And then, all of the sudden, it wasn’t. Outside of gaining access to all of their accounting records (and good luck with that), what kind of due diligence could have prevented this?

Our take? We believe the situation unfolding with MF Global is not indicative of failure in the system, but an isolated blow-up related to the decisions made by management regarding the company’s focus. There are no easy answers here, and the repercussions of any fraud at MF Global could shake the futures industry for years to come- but is this common among futures-focused FCMs? Absolutely not. MF Global went a different direction than the rest of the industry, and that is why these problems exist, in our opinion. It is what they were doing- not of the industry they were doing it in.

Perhaps if Corzine had succeeded, we would have seen more FCMs try and copy that success, but the failure bodes well for the health of the industry now, being a stern warning for any firms which decide to juice their returns by dabbling in other areas.

To read more Managed Futures research pieces, visit Attain’s Managed Futures Newsletter archive and our Managed Futures Blog.

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Forex trading, commodity trading, managed futures, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors.

The entries on this blog are intended to further subscribers understanding, education, and – at times- enjoyment of the world of alternative investments through managed futures, trading systems, and managed forex.  Unless distinctly noted otherwise, the data and graphs included herein are intended to be mere examples and exhibits of the topic discussed, are for educational and illustrative purposes only, and do not represent trading in actual accounts.

The mention of asset class performance is based on the noted source index (i.e. Newedge CTA Index, S&P 500 Index, etc.) , and investors should take care to understand that any index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices:  such as survivorship and self reporting biases, and instant history.

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Past Performance is Not Necessarily Indicative of Future Results. The regulations of the CFTC require that prospective clients of a managed futures program (CTA) receive a disclosure document when they are solicited to enter into an agreement whereby the CTA will direct or guide the client’s commodity interest trading and that certain risk factors be highlighted. The disclosure document contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA.

Copyright © 2011 Attain Capital Management, licensed Managed Futures, Trading System & Commodity Brokers. All Rights Reserved. Reprinted with permission.

Traditionally staid and conservative firm seeks buyers as concentrated bets in European Sovereign debt markets go badly wrong

Opinion:

In an episode of art imitating life, the movie Margin Call depicts a financial services firm that concentrated all its risk in one sweeping bet that went badly wrong. In the case of the movie, the trade that exploded in the debt markets of 2008 forced a financial services firm to liquidate assets in an attempt at survival. Fast forward to October 2011, and MF Global, one of the industry’s leading Futures Commission Merchants (FCM), is struggling for survival as it receives a real life margin call. As of this writing the New York Fed suspended conducting business with the firm and more significantly the CME Group has cut off trading access to the firm.

The eighth ranked FCM in 2010 with $8.6 billion under management, MF Global was, like many futures brokerage firms, following staid and conservative management principles that generally didn’t gamble company assets through proprietary trading. (In 2008 when a rogue Wheat trader made headlines by racking up $145 million in losses, such unauthorized trading wasn’t part of the firm’s management plan.)

Things changed rather dramatically during spring of 2010. This is when a gambler took the reins of power. As a result, the company is currently scrambling for liquidity to raise cash while its leader, former Goldman Sachs superstar Jon Corzine, might be looking at the numbers to figure out what went so very wrong. This might be similar to 1994 when Mr. Corzine was co-lead of Goldman’s fixed income group when it posted losses that almost took down the investment bank. But upon reflection, it looks more like the 2008 car wreck then NJ Governor Corzne was in while speeding down the expressway without a seat belt.

What Went Wrong?

With a University of Chicago background, a school known for producing strong quantitative minds, Mr. Corzine really needs to look no further than another U of C alumnus, Nobel Prize winner Harry Markowitz, to figure out why things went so bad so quickly.

As MF Global, one of the leading brand names in the futures and options industry, fights for oxygen and liquidity, Mr. Corzine’s significant concentration of risk towards a single market move in Sovereign debt highlights what is known as investment concentration. This means all risk in a portfolio might be influenced by one significant macro global force. In this case, when the credit markets in Spain, Portugal and Ireland logically fell apart without significant austerity measures in place, the bond investments and the fortunes of MF Global all lost value at the same time. This investment concept stands in contrast to Markowitz, whose Modern Portfolio Theory promoted the concept of asset diversification of returns streams, a cornerstone of proper derivatives risk management. Mr. Corzine might have missed that diversification memo.

There are several points of derivatives risk management Mr. Corzine and his well connected crew have ignored. Perhaps the most significant also was related to a debt issue. While at Goldman Sachs, Mr. Corzine and those designing non-transparent derivative products were witness to a warning from a demure female with a powerfully strong will: Brooksley Born.

Ms. Born was CFTC Chairwomen when, in 1998, she sounded alarm bells regarding non-transparent and toxic derivative products that were not managed in accordance with open, transparent and regulated rules that existed in the exchange traded derivatives markets. While she and her prophetic call for transparency into toxic assets were generally ignored – and she was effectively muzzled by a “Working Group” in Washington D.C. that existed of the likes of Alan Greenspan, Larry Summers and former Goldman alumni Robert Rubin and Timothy Geithner – Ms. Born eventually resigned office on June 1, 1999. The toxic assets to which Ms. Born’s warnings were targeted famously exploded in fall of 2008. Ms. Born, her ignored warnings now vindicated, nonetheless keeps professionally quiet on the topic, letting facts speak for themselves.

The History of a Debt Crisis

After losing re-election as Governor of New Jersey in 2009, Mr. Corzine set his sights on making his mark in the derivatives world again when he replaced former Chicago Board of Trade president Bernard Dan as CEO of MF Global on March 23, 2010. While his results at MF Global were similar to his re-election attempt, Mr. Corzine made a different choice in the derivatives markets this time around. Instead of non-transparent off-exchange mortgage derivatives, Mr. Corzine chose the regulated derivatives industry when he took the reins at an FCM that had deep historic roots tracing its roots dating back to 1783 when English commodity trader James Man founded the firm. Little did anyone know at the time MF Global, long considered an industry icon of sorts, was now on a path to being sold off in bits and pieces in a fire sale to the highest bidder.

Upon taking control at MF Global, Mr. Corzine had two choices: he could gamble, rolling the dice on a heavy concentration to Sovereign debt, or he could have chosen the path of popularizing a defensive investment portfolio that includes a diversity of returns streams – a concept championed by a host of academic thinkers and investment practitioners. Mr. Corzine’s choice speaks to a lost opportunity at this moment in economic history.

In choosing to gamble with Sovereign debt assets over focus on integrating uncorrelated investments into traditional stock and bond portfolios, Mr. Corzine wasn’t looking to the future, which is unfortunate. Upon taking over MF Global, he quickly stated his long term vision was one of logical asset management, transforming the FCM into the next big thing on Wall Street. This gave those in the managed futures industry reason to cheer. In the end, however, he couldn’t overcome his past where significant risks were taken – some that worked, some that didn’t. The difference between Goldman Sachs and Corzine’s MF Global is that Goldman often takes the both sides of trades – as they did in the mortgage derivatives crisis. At least they embrace the concept of diversification of risk and returns streams. Mr. Corzine’s concentration concept just didn’t work out.

“You shouldn’t risk more than you can lose,” noted veteran industry observer John Lothian. “This goes for traders as well as brokerage firms.”

What’s interesting here, the overlooked component is that Mr. Corzine gambled from within the futures industry which is known for “gambling.” However, the opportunity Mr. Corzine missed is the industry is really based on risk management and hedging, not raw speculation. The growing futures industry movement is away from raw gun-slinging speculation, to embracing logical asset management with an investment generally uncorrelated to the stock market through managed futures. It is an industry increasingly looking like an insurance company with probability tables and less like that represented by the Wild West and a gun slinger attitude of investment concentration. Unfortunately Mr. Corzine chose making his highly concentrated leveraged bets in Sovereign debt markets rather than expanding the concept of uncorrelated investments.

It’s in the uncorrelated investing concept that many on Wall Street seem to have problems. Perhaps it was the message about an investment that operates independent of economic strength that just didn’t jive with Mr. Corzine? Or it could have been the industry concept of account segregation and transparency where he might have missed the derivatives management memo? Clearly the defensive concept of true diversification didn’t resonate.

There is a movement in the futures and options industry away from the cowboy speculator and towards a logical and risk-focused investment. This is the direction many had hoped Mr. Corzine would take MF Global, the brokerage firm once considered industry legend. But that, apparently, isn’t going to happen.

As Mr. Corzine and Company are managing their margin call, liquidity drying up all around them, the opportunity to expand the concept of diversification with investments uncorrelated to the performance of the stock market might have received a temporary set-back. However, as a looming US government debt crisis that won’t go away easily becomes better understood by those including Mr. Corzine, the concept of true asset diversification is something that should not be ignored at this moment in economic history.

Mark H. Melin is currently writing his fourth book on uncorrelated investing.  He is previous author / editor of three books, including High Performance Managed Futures (Wiley, 2010) and an adjunct instructor in managed futures at Northwestern University.  He can be reached at markhmelin@yahoo.com

Contents of this article Copyright (C) 2011 Mark H. Melin.

Risk Disclosure: Managed futures can be a volatile investment and is not appropriate for all investors.  Past performance is not indicative of future results.

The opinions expressed in this article are those of the author, may not have considered all risk factors and may not be appropriate for all investors.

The Occupy Wall Street protesters and their sympathizers are catching a lot of grief from well, people who work on Wall Street, and from some members of the media friendly with those who work on Wall Street. They say the protests lack reasonable goals and there is no clear end-point. One might also surmise there is a sense of unease about having several hundred people who don’t like you and despise your line of work camped outside your office day-in and day-out.

And yet, it’s not just the camped-out protesters who sense things are amiss in the world of finance. Paul Brodsky of QB Asset Management told Barron’s the protesters are “credible,” and that they represent “a ‘disenfranchised majority that is quickly growing disenchanted’ with our financial system and its workings.”

Kynikos Associates’ Jim Chanos and PIMCO’s Bill Gross have said they understand the protests. Chanos told Bloomberg on Oct. 11, “People are angry, they feel the game is rigged and they didn’t get their fair shake.”

Citigroup’s Vikram Pandit called the protesters’ sentiments “completely understandable.”

And just today, Leon Cooperman of Omega Advisors without explicitly saying he supported Occupy Wall Street—who knows, maybe he doesn’t—leveled some of his own criticism of the markets. Cooperman said at the Value Investing Congress in Manhattan that high-frequency trading “has turned the market into a casino,” and that he supports the return of the uptick rule to do away with it, as well as limits on who can participate in the credit default swap markets and reining in speculation in exchange-traded funds. (more…)

Keefe, Bruyette and Woods’ analyst Brian Gardner says complying with the new Volcker rule will be a bigger headache for banks than lost revenue from banning proprietary trading.

“Banks have never really disclosed with great specificity exactly what prop trading is and what percentage of their business is involved,” Gardner says. “The GAO did a study that came out several months ago, and they looked at the losses and profits over, I think it was a four-year period, and for the major banks, if you look at the numbers, they were not that large. I mean, they were, you know, we’re talking about billions of dollars in profits over a multi-quarter period spread over several banks. So my guess is, and I’m not a fundamental analyst, but sitting from a policy chair my guess is that the impact on the business models is not going to be as great as people have feared.” (more…)

U.S. banks must acknowledge their stark outlook, says CLSA’s Mike Mayo, who predicts low yields and high expenses will usher in the worst decade of revenue growth since the Great Depression.

“It’s when banks don’t recognize the reality and try to grow faster than the natural rate of growth in the environment, that’s when they get into trouble,” Mayo says. “So it doesn’t have to be life-threatening that banks don’t have very good revenue opportunities, but in response banks need to show risk discipline and also control their costs.” (more…)

Reuters Breakingviews editors Robert Cox and Anthony Currie say Bank of America Chief Executive Brian Moynihan should seek out prominent investors to take a stake in his bank and reach an agreement with those who have sued the bank over its mortgage practices.

“You get this sense … there’s this sort of almost like a 2008 crisis mentality to the place – shooting the messenger….” Cox says. (more…)

Ken Griffin’s Citadel hedge fund firm is abandoning its foray into investment banking. Internal clashes didn’t help, and bulge-bracket firms held up better than expected. As it turns out, Wall Street turf has some solid defenses. Reuters Breakingviews columnist Antony Currie discusses Citadel’s pullback with Reuters Insider’s Rhonda Schaffler.

“The whole way of setting up an investment bank takes time, patience, money and very often doesn’t work,” Currie says. “So Citadel is a hedge fund with one particular culture – you hire in a bunch of bankers who are very good at, say, Merrill Lynch or Deutsche Bank. But were they actually the best people to build a franchise from scratch? Maybe they were, maybe they weren’t. There was that, but there’s also maybe they conflicted with what the hedge fund guys wanted.”

Read the Aug. 11 HedgeWorld story on Citadel’s move here. (more…)

Crummy trading revenues are forcing banks to tighten their belts. Rob Cox, New York Times reporter Susanne Craig and Reuters Breakingviews columnist Antony Currie discuss the cuts that are yet to come and why.

“I think we lived through Armageddon in 2008, but it’s not going to be great,” Craig said. “I mean, some of these guys (the banks) are looking at 5%, 10%, 15% reductions. That’s a lot.” (more…)